Inflation is the sustained increase of the price level. The rate of inflation is the change in general price levels over a period. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in purchasing power per unit of money. The opposite of inflation is deflation.
A year is chosen as the base year and this year has a value of 100, while subsequent changes over the years are expressed as a percentage change in the base year. Weighing the average price of a basket of goods that a typical household in that country buys measures the price index. Economists refer to this as a “market basket.” Since all goods aren’t of equal value to the consumer, i.e., food vs. mobile phone, a weight is assigned to each good by calculating the proportion of the price of the good to the total expenditure.
Different countries use different measures of inflation; in North America, there are two main price indexes.
1. Consumer Price Index (CPI)
A measure of price changes in consumer goods and services such as gas, food, clothing, and automobiles. The Consumer Price Index (CPI) measures price change from the perspective of the purchaser.
2. Producer Price Indexes (PPI)
A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.
Problems with Measuring Inflation
1. Difficult to Assign
It is difficult to assign a basket of goods, because it has to be taken into account the need and consumption of all consumers in the country.
2. Substitution Bias
Since a weight is assigned to a good, an increase in that good’s price might increase inflation, but in reality, consumers might move to a substitute good. This is known as ‘substitution bias.’
3. Time Lag
New goods take years to enter the ‘basket of goods.’
4. Quality Bias
Sometimes there might be an improvement in the quality of the product, but it may be slightly more expensive than the cheaper lower quality product, which will last less longer, making it relatively more expensive. Thus, the cheaper product may overestimate inflation. This is known as ‘quality bias’.
Costs of Inflation
1. Market Uncertainty
It increases uncertainty in business decision-making and could make investments less profitable. Thus, investment decreases and growth and employment may fall too.
Exports become more expensive, so they become less competitive abroad and as a result net trade may decline.
Households experience a fall in purchasing power.
There is a distortion in the market because of relative price changes.
It results in further inequality of distribution of wealth and income as the poorer have fewer options against inflation and limited borrowing capability.
If inflation is higher than expected, then lenders lose as the money they get back is worth less than the money they lent.